7/05/2004 @ 12:00AM

Hedge Hell

Two slick funds promised dozens of executives a way to get off the market roller coaster. Instead they lost hundreds of millions of dollars.

Alex Brown likes to steep itself in its two centuries of history, proud to have financed the nation’s first water utilities and railroads. But two new lawsuits paint a disturbingly different picture of America’s oldest investment bank, alleging fraud, mismanagement, inept options trading and conflicts of interest. Even more surprising is the source of the suits: several dozen executives at Yahoo, Ask Jeeves and other big-name firms.

“Even the biggest fish in the pond can get screwed,” says plaintiff Philip McKee, the former chief executive of TurboChef Technologies. “If they can do it to us, they can do it to anyone.” Among the alleged screwees:Yahoo cofounder Jerry Yang (who put in $3 million); Bruce Toll, cofounder of homebuilder Toll Brothers ($1 million); former Ask Jeeves boss Roger Strauch ($1 million); and former Omnipoint chairman Douglas Smith ($3.7 million).

In 1997 and 1998 some 170 highly sophisticated investors, many of them techies flush with soaring stock options, put $286 million in stock into two so-called exchange funds. The funds are designed to let execs diversify beyond their own company stock–and dump insider shares without full disclosure or having to pay taxes on any gains. But the clients lost hundreds of millions of dollars, the suits claim,when the two funds bet wrong as tech stocks rocketed up in 1999, then bet wrong again when the market fell.

In the chaos the funds borrowed massive sums to keep afloat and abandoned the strategies that had backfired so badly–yet they issued opaque, generally sanguine updates to their investors, the suits allege. Alex. Brown is accused of failing to step in because it savored the rich fees:$25 million shared with the two managers for one of the funds, plus millions more for providing them with margin loans and stakes in mutual funds and private equity funds.

The two suits, filed in May in Superior Court in Delaware, list a total of 70 plaintiffs; from their peak to their trough in early 2003, the two funds declined $500 million. By some reckoning, they are down 50% even after the tech recovery. The suits target Alex. Brown; its parent, Deutsche Bank; the funds’ board; and the funds’ managers: D. Robert Crants and Michael Devlin, 28 and 37 respectively, at the time of the funds’ launch, both of them alumni of Goldman Sachs. Among their alleged misdeeds:that the two men put $7.5 million into a moneylosing real estate firm they controlled and that they invested $5 million in a venture capital fund run by a fund board member.

Crants and Devlin have been hit with still other allegations. They ran a side business buying prisons that was named in now-settled securities class actions. They also managed two private equity funds that received $15 million from Nashville’s pension fund; an auditor’s report said the deal involved conflicts of interest and almost no due diligence. Crants and Devlin were not named in any suit, but the city sued UBS PaineWebber, whose brokers had advised it on funds. In 2002 it paid $10 million to settle.

In the Alex. Brown suits, lawyers for the two managers and Deutsche Bank say the charges are without merit and will be fought “vigorously.” The lawyer for the board had no comment. In court the defendants likely will argue that the investors were given ample warning of the risks; offering documents caution that the hedging strategy was “speculative” and carried “significant risk of loss.” A similar suit in a Baltimore circuit court was dismissed pending a more detailed filing by the plaintiffs.

The two funds started in the halcyon days of the late 1990s, when tech stocks soared. Techies in particular were looking for ways to hedge their rising stocks. The Alex. Brown exchange fundsinvited them to transfer their own stock into the fund in exchange for shares in the fund itself. Then, to diversify and earn better returns, the funds would use the stock as collateral to borrow cash and invest it in mutual funds and private equity. They usually hedged using risky options; much of the hedging was based on the fluctuating value of company shares in the fund. But the funds promised to avoid selling any of the contributed shares to raise money, so as not to trigger capital gains taxes that the investors would have to pay. That would hurt later on.

Disclosure was sketchy from the start; the funds listed contributed stocks but allegedly didn’t reveal details, such as the amount held of every stock. Both funds, tech heavy because of their clientele, got killed selling call options that gave holders the right to buy tech stocks in the funds. When tech soared, holders cashed in their call options–but the funds couldn’t hand over underlying stock, because that would trigger taxes for the funds’ investors. So they borrowed cash to pay the call holders; in July 1998 one fund had $161 million in debt, or 46% of assets, up by two-thirds in three months.

In 1999 the same fund allegedly lost $88 million in options trading. Worse, when the funds halted all options trading that same year, they lost the protection they had acquired in case of a market plunge. When the market did plummet, soon afterwards, the banks stopped lending to the funds, which were then forced to turn to Alex. Brown and elsewhere for higher-cost margin loans. Loan defaults were not promptly reported to investors. Also, one fund had to sell $95 million in contributed stock, nearly all of it inflated Yahoo stock from Jerry Yang. But the funds, having gone for over a year without issuing any results to their clients, allegedly spoke nary a word about the cash crunch. The suit says Deutsche Bank eventually fired four of the funds’ five board members. Undeterred, Crants and Devlin have started a new fund for their private equity group Pharos Capital. On their Web site they quote one client who calls them the “definition of smart money.”